A seasonal summer boost in the municipal bond market has yet to materialize, but value has emerged and investors are taking notice. Municipal valuations are at their most attractive levels of the past several years, according to average municipal-to-Treasury yield ratios. Average 10- and 30-year AAA municipal bond yields are 112% and 114%, respectively, of comparable maturity Treasury yields (using Municipal Market Advisors yield data) as of July 10, 2013. The higher the yield ratio, the more attractive municipal bonds are relative to Treasuries and vice versa. A ratio over 100% means that yields on top-rated municipal bonds are exceeding those of comparable Treasuries, and investors get the added tax-benefit to boot.

In recent years, municipal-to-Treasury yield ratios have often reached or exceeded 100%, and that condition by itself does not necessarily spark a rally. However, ratios in excess in 110%, which imply a cheaper valuation on municipals bonds due to a greater yield advantage, are rare and have generally provided a good opportunity to municipal bond investors. Over the past three years, ratios in excess of 110% occurred in early 2011, during the fourth quarter of 2011, and again in mid-2012 in addition to today’s environment. In two of those cases, late 2011 and mid-2012, ratios remained elevated above 110% for weeks, so valuation improvement did not come immediately, but patient investors have been rewarded.

Over the last four years When the 10-year AAA municipal-to-Treasury yield ratio has exceeded 110%, the broad municipal bond market, as measured by the Barclays Capital Municipal Bond Index, has returned an average of 3.9% over the subsequent six-months. That return data includes the mid-2012 period when the 10-year Treasury yield bottomed at 1.39% during July 2012, and top-quality municipal yields were not far above record lows of their own. Even during the yield-challenged period of July 2012, municipal bond returns over the subsequent six-months ranged from 1.5% to 3.0%. While those returns may not be exciting for some, it shows performance may improve compared to what investors experienced over recent weeks.

Chart: Municipal Valuations Remain Near Their Most Attractive Levels of the Past Few Years

We caution against reading too far into historical returns as the threat of the Federal Reserve (Fed) removing stimulus from the bond market bond and the prospect of higher yields are likely to limit the potential price appreciation. However, with top-rated 10-year municipal bond yields at their highest levels since the second quarter of 2011, yields are higher than prior periods of attractive valuations such as late 2011 and mid-2012. In fact, early 2011 (in response to Meredith Whitney inspired weakness) was the last time 10-year municipal bond yields were near, or above 3%.

The municipal market currently remains burdened with supply both from the new issue market and also in the secondary market due to recent mutual fund redemptions, according to Investment Company Institute ($16.5 billion outflows during June). Investors will therefore need patience as the supply overhand may bring additional periods of weakness. On a positive note, the strong reception of new issuance since late June indicates investors have taken note of the recent rise in yields and cheaper valuations. Some new issues were priced to move but nonetheless, a more consistent buying base is emerging compared to the void of May and June to take advantage of some of the highest yields of the past three years.

Investors may wish to consider intermediate and long-term maturity municipal bonds. In addition to higher yields, valuations are more attractive relative to short-term bonds and both segments enable investors to take advantage of a steep yield curve. The yield differential between 2- and 30-year AAA municipal bonds has increased by 1.0% since May 1 to 3.6%, the greatest since mid-2011. Investors are therefore more rewarded for extending maturities compared to just two months ago. Intermediate, long-term, and high-yield municipal bonds were among the hardest hit during the recent sell-off and may stand to benefit most from any stabilization in the municipal bond market. Finally, a favorable summer seasonal period, which has been delayed due to recent weakness, may provide an additional tailwind once supply pressures ease.

About Anthony Valeri

As Senior Vice President and Market Strategist, Anthony is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy. Anthony regularly communicates market strategy to LPL Financial advisors, contributes to the Research department’s flagship publications, is a speaker at LPL Financial conferences, and authors Bond Market Perspectives, a weekly client commentary on the bond market. Anthony has been quoted in a number of national online and print publications including Bloomberg News, Reuters, and Dow Jones. Prior to joining the Research Department in January 2002, Anthony was Head Trader of the LPL Financial fixed income-trading desk. Anthony has 18 years of investment experience.

Anthony received a BA in Quantitative Economics and Decision Sciences from the University of California at San Diego in 1992 and received his Chartered Financial Analyst designation in September of 1999. Additionally, Anthony is Series 7 and 63 registered. Anthony is a member of both the Association for Investment Management and Research and the Financial Analysts Society of San Diego. Anthony has been with LPL Financial since June 1993.

Important Disclosures: The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Municipal to Treasury Ratio is a comparison of the current yield of municipal bonds to US Treasuries.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

Municipal Market Advisors (MMA) is an independent strategy, research and advisory firm.

The Barclays Capital Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.